Perennial China Retail Trust IPO 鹏瑞利中国零售信托

After visiting vacant new malls in China, I was naturally intrigued to know the rationale behind this Chinese mall IPO on the Singapore Exchange, which was originally scheduled to go public in March 2011 but was then delayed until June 9th and priced 30% lower. The rationale may become more apparent by the end of this post.

The press release stated that “PCRT offers investors the unique opportunity to participate in urbanisation-driven retail growth opportunities in China via a private-equity fund structure, typically accessible to only large institutional investors…PCRT's initial portfolio comprises five assets located in Shenyang, Foshan and Chengdu. The assets are Shenyang Red Star Macalline Furniture Mall, Shenyang Longemont Shopping Mall, Shenyang Longemont Offices, Foshan Yicui Shijia Shopping Mall and Chengdu Qingyang Guanghua Shopping Mall, and have a total gross floor area of approximately 960,899 sq m [10,343,369 square feet] and a total valuation of approximately S$1.1 billion as of December 31, 2010. …” The common special attribute for each property is that it will be served by either rapid transit or high speed railway stations.

Only one of these projects has been completed -- the 3 million square foot Shenyang Red Star Macalline Furniture Mall, a nine-story furniture mall which opened last September and was reportedly 91.8% occupied by the end of the year. This mall exclusively sells home furnishings, building materials and furniture. The property manager is Red Star Macalline Furniture, China's most successful furniture retailer, with 66 stores throughout China, double the number of stores open in 2007.

Red Star Macalline has been successful in wealthy Chinese cities such as Shanghai (GDP per capita of $23,000); can it be successful in poorer cities such as Shenyang (GDP per capita of $9211)?

China Daily reported in March that home improvement retailers in China are facing growing challenges. French retailer Saint-Gobain recently shut down all its Shanghai stores, stating that "the individual demand for interior settings is dwindling since more housing and apartments will be sold with interior decorations. Our business, which is based on individual demand, becomes increasingly difficult." Likewise, Home Depot has closed 5 of 12 stores in China, and British home improvement chain B&Q has closed 22 stores (including Shenyang) and reduced the size of 17 stores out of a total of 63 stores in China. Perhaps the foreign retailers don't know how to compete with Chinese retailers, but a recent statement from a VP at China Building Materials Circulation Association sounds ominous: "The need for building materials is falling because people, even those needing houses to get married, are watching the property market instead of buying houses and decorating them. They expect housing prices to fall significantly."

That's the problem with the home furnishings and building materials industry -- it is dependent upon a robust housing market, and if that market were to deflate, like it did in the U.S. and U.K., the home furnishings industry would deflate, too. This would suggest that furniture malls could experience increased vacancies during the next Chinese recession, just as many furniture retailers failed during the U.S. housing bust.

Meanwhile, Standard & Poor’s cut its outlook on Chinese real estate developers to “negative” from “stable” on June 15 because of government tightening of credit markets, which may lead to further rating downgrades in the next year. The Chinese government has increased the required reserves for bank lending on commercial real estate nine times in a row.

Realistically, though, could one really put over 800 competitors together and expect all to survive? Red Star isn't a conventional mall with tenant complementarity.

Another, more fundamental question to ask is whether China is really wealthy enough to support the large number of luxury shopping malls being built at one time, considering that the median household income there is only about 10% of U.S. median household income.

The remainder of the PCRT portfolio

The even-larger, adjacent, Shenyang Longemont Shopping Mall (3.5 million square feet) is scheduled to open in the third quarter and was said to be only 51.8% pre-leased to 185 tenants at the time of publication of the prospectus. The other projects will not be fully completed until the end of 2014. PCRT also claims to have S$3 billion (Singapore dollars, worth about 81 U.S. cents) worth of purchase options for commercial sites next to the coming High Speed Rail in China.

CEO Pua Seck Guan stated, "Among all the markets that I'm familiar with, I think that China offers the most exciting and best potential. The reason being, one, today you can get real estate at a very attractive price, and you can see the yield that you can get. Therefore you can see the arbitrage of the physical market value into a capital market. “

If that statement doesn't make sense to you, you can understand why I'm skeptical, too. I would have more confidence if Mr. Pua just said, "I want to build profitable malls" rather than "I want to make a 'pure play' on Chinese retail." The latter statement resembles the talk of a gambler rather than a businessman. Bernie Madoff also liked to use the word "arbitrage."

One must also never forget that these are all leasehold properties, with ground leases expiring in 38 to 40 years, which reduces the prospects for long-term capital appreciation. This is China, remember; everything is leasehold. Yet Pua's justification for the initially below-average yield was the superior prospects for capital appreciation in this property portfolio.

The Feasibility Study

It is interesting to see how the 594-page PCRT prospectus has placed a positive spin on a February 2011 feasibility study from Urbis of Australia that presents more cause for concern, particularly about Shenyang, where three of the five properties are being developed. The IPO prospectus represents the Shenyang retail occupancy rate as 95 to 100%, but the feasibility study indicated an overall 83% occupancy rate for Shenyang shopping centers, most of which were built in the last decade. The report also mentions other competitive malls under construction in the same East Zhongjie neighborhood of the Dadong section of the city, such as:

Tianrun Plaza East Zhongjie 130,000 sq mtr Shopping Mall
Fengrui East Zhongjie 325,000 sq mtr Department Store
East Zhongjie Plaza 580,950 sq mtr Shopping Mall
Dunan Qiansheng Mall East Zhongjie 230,000 sq mtr Shopping Mall

This represents 1,265,950 square meters, or 13.6 million square feet of oncoming competitive retail space in the same part of town on top of an existing inventory of 340,000 square meters, a quadrupling of retail space in the East Zhongjie area alone, but does not mention the scope of the 4.37 million square meter (47 million square feet) Longemont Asia Pacific Centre mixed use project the PCRT properties are a part of, which also includes in its first phase the following competition:

1. The 32,000 square meter Asia-Pacific Department Store
2. The 100,000 square meter Asia-Pacific Digital Mall
3. The 25,000 square meter Regent Department Store
4. A 400,000 square meter major department store
5. A 30,000 square meter Vogue Department Store

That's 587,000 square meters (6.3 million square feet) of adjacent competitors within the Longemont Asia Pacific Centre development.

What will vacancy rates be like one year from now? Will these new malls and department stores draw away tenants from the PCRT malls?

From Savills Research and Consultancy -- The red square represents the three Shenyang projects situated in East Zhongjie.

As for local spending power, the study indicates annual retail expenditures per capita of just RMB 8926, or about $1377 USD. Is this supportive of “mid to high end retail”? There seems to be a misconception among foreign investors that most Chinese people are now affluent.

The feasibility study’s conclusion of feasibility would offend the reason of any numerate person:

"Given the expectation for continued strong economic growth and growth in personal incomes, the impact of any ‘oversupply’ is likely to be reasonably short, with the market adjusting over the following couple of years."

This would imply that a quadrupling of retail space in the neighborhood could be matched by a quadrupling of local retail spending within two years. Anyone who has completed Lesson 1 of Economics 101 would be skeptical of such a conclusion. The report lacks quantitative analysis of supply and demand, such as a forecast of local retail space absorption or vacancies, and this verbiage is similar to the positive feasibility studies done to justify failed projects in Las Vegas, Arizona and Florida.

Despite the deluge of new space being developed, the Sponsor has assumed a 1% vacancy rate for the retail malls, continued 6% annual growth in rental income and 15% annual growth in retail spending.

The Red Star Mall has opened to reported occupancy of 91.8%, but will a one-concept mall have staying power, particularly if the housing market was to recede?

As far as the talk of “yields you can see” is concerned, only the Shenyang Red Star Mall is producing income at the moment, and the malls in this trust will not be fully operational until the end of 2014. The IPO sponsor has forecasted a 5.3% yield in 2011, a tall achievement from mostly unfinished malls. The first distribution will be from the Earn-out Deed, which was taken out of the offering proceeds and is thus a return of capital and not a return on capital.

The reason for an IPO outside China

The use of an IPO on a foreign exchange to get financing is a result of the Chinese government’s crackdown on commercial real estate lending by banks. Escalating reserve requirements have hamstrung the ability of Chinese banks to lend on commercial real estate development, so developers must look outside China for financing. Somehow, sponsoring a risky real estate project on a foreign stock exchange gets taken seriously as an investment grade project.

The valuation [appraisal] report

The PCRT portfolio was valued at the equivalent of S$1,132,906,000 as of December 31, 2010, and the initial IPO was scheduled to be 1.1 billion shares priced at S$1 per share. The IPO was then postponed until June and finally fully subscribed, selling 1,121,695,000 shares at 70 cents per share (SGD), or S$785,187,000, 30% below the previously appraised value of the properties.

The S$1.1 billion valuation seems questionable, though, if it is meant to represent the current value of the intended PCRT portfolio as of December 31, 2010, as the independent valuation report does not disclose until the Appendix that the estimates of value were based on hypothetical conditions, mainly that all 5 properties were built, fully leased, and fully owned by PCRT. The only open and leased property, the Shenyang Red Star Mall, was valued at about $186 SGD psf, but the other incomplete or unbuilt properties were given similar appraised values. The incomplete Shenyang Longemont Mall was valued at S$187 psf and the incomplete Longemont Offices were valued at S$193 psf. The unbuilt Foshan mall was valued at S$205 psf and the unbuilt Chengdu mall was valued at S$156 psf. These estimates of values could not be reflective of the condition of these properties on December 31, 2010, making the valuation report misleading and inaccurate, as two of the five assets are currently just purchase options for projects that have not yet been developed.

Such a valuation report, if published in the U.S., would be considered a "misleading report" in violation of U.S. appraisal and banking laws. In the U.S., prominent disclosures of such hypothetical conditions affecting appraised value are legally required to be in the body of the valuation report; it surprises me that squeaky-clean Singapore does not require disclosure of misleading “hypothetical conditions” for a public IPO.

Moreover, the valuation report in the prospectus did not even consider that PCRT was acquiring only a 50% interest in the Shenyang properties, so they mistakenly valued the portfolio for 10.152 billion RMB (about S$1,932,000,000) and PCRT was the one to make the adjustment for 50% ownership in the prospectus.

Investors need to realize that whenever an IPO sponsor orders an independent valuation or feasibility study, that study cannot be considered truly “independent”. The only independent study investors can rely on is one they order for themselves. Sorry to say this, being a valuer [appraiser] myself, but too many valuers are paid whores.

How the sponsor benefits from the IPO

So given the risk and uncertainty, what’s in this IPO for the Sponsor? The sponsor is appointed as the “Trustee-Manager” and is compensated as follows:

1. An annual base fee of .35% of appraised value up to S$10 billion. Based on the inflated CBRE valuation of $1.1 billion, the Sponsor would be owed S$3,850,000 this year. Will the Sponsor keep hiring this same valuation firm?
2. A performance fee of 4.5% of net property income (on top of the management fee paid to the actual property manager, Red Star Macalline).
3. An annual trustee fee of .03% of appraised value, or S$330,000 this year.
4. An acquisition fee of 1.35% of the acquisition price of the properties in Shenyang and Foshan ($820,000,000 SGD), which would provide the sponsor another S$11,000,000 in compensation.
5. Development and property manager’s fees of 2% of gross revenues + 2% of net property income + .5% of net property income.
6. Leasing commissions of two months’ gross rent for newly completed or renovated buildings.
7. A divestment fee of .5% of the sale price of any real estate sold or divested.

The prospectus also indicates that PCRT's sponsor will earn S$141,800,000 in acquisition and development fees for the Chengdu Mall and S$121 million for the Foshan Mall. So development seems to be a profitable option for PCRT's Sponsor, no matter what.

The bottom line is the Sponsor is superbly compensated no matter what happens to the properties in this portfolio, much as a syndicator is (See my blog about international real estate syndications). The piece de resistance in this scheme is that the Trustee-Manager can only be removed by a 75% majority vote of the unit-holders, so desperate is the Trustee-Manager to hold on to this gravy train. This is even disclosed as a risk in the prospectus: “There may be difficulty in removing the Trustee-Manager.”

My overall opinion of PCRT is that it is bad for investors, but good for the sponsor. While advertised as a "pure play" on the Chinese retai sector, it is also a pure play on Chinese real estate development at an inauspicious time. For instance, Standard & Poors has just reduced its outlook to "negative" for Chinese real estate developers due to Government efforts to restrict bank lending to them.

My skepticism does not count for much. What does the market think?

The IPO was originally priced at S$1 per share, then 70 cents SGD per share. Trading in PCRT on the SGX started on June 9th at 65.5 cents per share, and in the two weeks since the unit price has declined to 58.5 cents per share for a market capitalization of S$656,191,525, which is 42% below "valuation".

Disclosure: I have no short or long position in this stock.

Related articles

• Where To Locate Your China Retail. Wake Up And Smell The Coffee. Literally?

  ---

NEW SOUTH CHINA MALL: WORLD’S LARGEST FAILED MALL 新华南

All photos were taken at about 1 pm on a Wednesday afternoon on a sunny day in May.

Having been an appraiser of distressed malls since 1984, I considered New South China Mall to be the Mount Everest of distressed malls. I finally got to visit this mall on May 11, 2011.

Completed in 2005, it is the world’s largest mall with leasable area of 7.1 million square feet, gross building area of 9.6 million square feet, space for 2350 stores, and a 99.5% vacancy rate.

What makes New South China Mall unique is that it has been mostly vacant in its 6 years since completion, and an inspection of the premises indicates that most of the few tenants this mall started with are now out of business. Press releases from the mall indicated that the mall had pre-leasing commitments from 1016 stores and opened with 386 stores.

New South China Mall was developed by an instant noodle billionaire, Hu Guirong, and financed with a billion-yuan loan ($154 million) from the Agricultural Bank of China, which was previously one of the Chinese government's "policy banks", banks that previously made loans based on government policy rather than on economic soundness. This was Mr. Hu's first retail development project, and perhaps he thought that once he had mastered instant noodles that he could master anything.

The mall's feasibility was supported by a study from the SMR Group in Guangzhou, which forecast 203,973 customer visits per day based on the reasoning that building the largest mall in Guandong Province would attract shoppers from as far away as Guangzhou and Shenzhen. This is analogous to building the world's largest mall in Newark, New Jersey, and expecting shoppers to come from New York and Philadelphia.

While I'm not sure if Chinese market research firms have the requisite skills to perform such a study, most feasibility studies, whether in China or the U.S., are typically ordered by developers to justify an over-reaching project and are thus not designed to be objective, any way. (Most lenders are too cheap to order feasibility studies and assume, to their detriment, that the appraiser they hire will automatically determine feasibility for them.)

The Founder Group, a high-tech company created by Beijing University, recently acquired a 50% interest in this property.

People in photo are a janitor and a security guard

Here are some of the factors that have led to the mall's failure:

Demographics

The mall is situated in the city of Dongguan, 50 km south of Guangzhou and 90 km north of Shenzhen. There is no doubt that the Guangdong Province of China has experienced a population explosion, with the cities of Guangzhou, Dongguan and Shenzhen having a combined population of over 25 million residents.

Dongguan is a sprawling industrial city of 7 million residents and about 900 square miles of incorporated area, more than twice that of Los Angeles. Dongguan does not match the affluence of the cities of Shenzhen and Guangzhou, though. If Shenzhen and Guangzhou were New York and Philadelphia, for example, Dongguan would be Newark, comparing cities based on personal wealth. Annual GDP per capita is $13,750 in Guangzhou, $14,245 in Shenzhen, but only $8187 for Dongguan. Similar to Newark, too, is its reputation for a high crime rate compared to its neighbors.

Of Dongguan’s 7 million residents, 5.2 million are classified by the Government as “permanent migrants”, most of who are young women who have come from rural areas to work in factories – not the sort to hop into a BMW to search for a Louis Vuitton purse at the mall. Most do not have cars. It is estimated that 75% of these migrant workers earns less than $200 per month, and some of that is sent home to even poorer relatives.

Furthermore, the mall is located in the less affluent Wanjiang district of the city, where the factories seem to be low-tech, manufacturing things like cabinets and display shelves and using mostly unskilled labor. (This area was described as farmland at the beginning of the mall's construction in 2002 but is now a fully urbanized area.) Unlike typical U.S. urban form with dying central cities and middle class flight to the suburbs, China's urban central business districts are thriving centers of commerce, and suburbs are for factories and low income housing.

Also complicating mall feasibility is the generally low level of household income in China, estimated to range from one-tenth to one-sixth of U.S. household income (and not officially measured), and the Chinese are known as being savers, too. Too much attention has been spent on the relatively small class of nouveau riche known for its conspicuous consumption. (See my blog post on Macau.) Western-style malls are a recent arrival in China, and seem to work better in the wealthiest cities, such as Shanghai, than second-tier cities like Dongguan.

Despite Dongguan’s recent growth, there are now widespread reports that factory workers are leaving for better paying jobs in Shanghai and other high-value manufacturing cities.

"Strength-accumulating quietness"

Accessibility

Super-regional malls are dependent upon freeway accessibility. For instance, the 520-store Mall of America in Bloomington, Minnesota, is located near the junction of Interstate 494 and Minnesota State Highway 77. The 800-store West Edmonton Mall in Edmonton, Alberta, is located near the junction of the 2 and 216 freeways in Edmonton.

On the other hand, the highways leading to the New South China mall are tollways owned by Dongguan Development Company Ltd (not the government), with tolls ranging from 17 to 25 yuan (about $2.60 to $3.85 -- customary tolls for New York City drivers, but not for underpaid Chinese workers).

There seems to be a lack of convenient public transportation to the mall, too, considering that the mall is not in a central location and Dongguan itself is a sprawling city that has grown without the benefit of rational urban planning. Dongguan has grown without urban planning from 28 factory towns that ultimately grew into each other. With an area of 2500 square kilometers, most Dongguan residents would need to take multiple bus rides to get to the mall.

There is also an inter-city bus station with an entrance approximately one km west of the mall's entrance, but no easy pedestrian access to the mall. Even then, inter-city bus fares are typically more than $15, once again too expensive for the average area resident.

To get to the mall, I took a train from Shenzhen to central Dongguan and then took a 55-km cab ride the rest of the way, having to also pay for the cab driver's 98 yuan in tolls (about $15) for the 110 km round trip. The drivers at the taxi stand all knew about the mall, yet my driver could not find the mall when on the same street and had to call the mall several times before the phone was answered. When a local taxi driver cannot find a mall that has been the world’s largest for the last 6 years, that mall is indeed in trouble.

Visibility

The mall site is mostly obscured from the main road by its high building profile (4 stories) and minimal signage. The cab driver and I almost passed the mall before realizing we had reached our destination, as the entrance, as seen in the satellite photo, is only about 100 yards wide. The only leased spaces were the ones visible from the main road through this 100-yard aperture.

No anchor tenants

There is no department store currently anchoring this mall, but the official mall web site states that the mall was originally supposed to be anchored by 1) a Causeway Bay department store of more than 400,000 square feet and 2) a KFC (?!). Other intended anchor tenants were OMOMO out of Hong Kong, OBI out of Germany, and Sundan Electronics. I do not know if these other stores ever opened.

In keeping with the mega-mall concepts of the Mall of America and the West Edmonton Mall, New South China Mall is situated around a miniature amusement park with children’s rides and canals with gondolas, like the Venetian in Las Vegas. At the time of my visit at 1 pm on a Wednesday afternoon, there were no shoppers, but several dozen school children in the amusement park. Out of about a dozen tenants, the three tenants doing business at that time were McDonald's, KFC, and Kungfu (a Chinese fast food restaurant with Bruce Lee as its emblem), all visible from the street and also patronized by amusement park patrons.

The theme park concept was said to be inspired by the success of the Window of the World theme park in Shenzhen, but Window of the World is almost 20 years old and was the original theme park in Guangdong province, which now has 40 theme parks, 12 of which were bankrupt as of 2007.

Hark! A customer approaches McDonald's, the mall's leading tenant.

Other Functional Problems

I found it odd that there were no mall maps to be found in the world's largest mall. Any other Western mall one-twentieth its size would have maps.

I was also surprised to find myself trapped inside the mall, too, when trying to exit to the interior courtyard/theme park, which means that the shops are conversely just as inaccessible from the theme park. There are too few entrances to the enclosed shopping area. There were no shoppers or open stores in the enclosed areas I visited, and the entrance to the McDonalds was closed from the interior of the mall.

The design team for New South China Mall visited more than 100 malls worldwide to collect the best design ideas, but they apparently focused only on aesthetics and not on functionality or accessibility. It is an attractive setting, with re-creations of seven different parts of the world, such as Rome, Paris, and Amsterdam, but little thought was made to how customers would find the mall or move around in it once they got there. There is a replica of L'Arc de Triomphe, though.

Retail competition

Having previously lived in America’s most Chinese city for several years (Monterey Park, California – 56% Chinese) and traveled to many Chinese destinations, I have never known a Chinese community to be under-retailed (having a lack of stores); theirs is an entrepreneurial culture. The SMR Group's feasibility study assumed the trade area to be the entire Pearl River Delta (including the larger and wealthier cities of Guangzhou, Shenzhen and Hong Kong), assuming that building the world's largest mall would effective draw away customers from the 15 other super-regional malls (more than 1 million square feet) that were built in Guangzhou and Shenzhen between 2001 and 2003, most of which also suffer from high vacancies. Could New South China Mall be way more retail space than Dongguan needs?

The failure of New South China Mall is also symbolic of a fundamental disconnect between mall development and actual income levels throughout China as empty luxury shopping malls start cluttering the nation. Household incomes are still well below those of more developed Asian states such as Singapore, Hong Kong, Taiwan, Japan and South Korea. The recent decade of mega-mall development in China reflects a naive hubris that presumes that the biggest mall will therefore attract the most shoppers.

PS: For hilarious hyperbole and misuse of the English language, be sure to visit the mall's English language web site www.southchinamall.com.cn/english. The mall is described as "a pacemaker" (perhaps meaning "pace-setter", a pacemaker being the little machine that keeps Dick Cheney's heart from stopping), and "a grand symphonic epic with high tone of traditional wealth revolution, investment revolution, consumption revolution and leading commercial trend of the time and vogue life style",..."highly hailed by experts, scholars, authoritative media and the society, as an international commercial empire". It even discloses that some Chinese economists were initially skeptical of the feasibility of the mall, but now "South China Mall has demonstrated its elegancy and glory, and is bound to be a miracle of commercial history." That was written a while ago. Now the mall is experiencing "strength-accumulating quietness" as the mall president, Kun Liu, has announced another 200,000 square meters (2,150,000 square feet) to be developed in an effort to somehow finally give the mall the critical mass it needs to compete against smaller malls (his opinion, not mine).

Related posts:

http://www.internationalappraiser.com/2011/06/perennial-china-retail-trust-ipo.html

http://www.internationalappraiser.com/search?q=shenyang
http://www.internationalappraiser.com/2012/04/red-star-macalline-malls-in-china.html

Related articles

• China Powerhouse Guangdong Turns Growth Laggard
• Dongguan Ghost Mall Haunts China's Property Boom
• Five ghost projects of China
• U.S. Manufacturers left China quietly
• The ghosts that haunt China's economic landscape
• A Chinese Mega City Is On The Verge Of Bankruptcy
• China: too many malls
• Plans for world's largest shopping mall announced

Beijing housing shortage

Typical Danwei-type housing for middle classes

Luxury housing for upper classes





Beijing is one of those boom towns that suffers from a severely constricted housing supply, despite valiant state planning efforts. Whether in a centrally planned economy or an exclusively market-driven economy, though, this is a natural occurrence that comes from rapid economic growth. Rapid growth is hard to plan for, although China has been known to build residential communities in anticipation of growth, sometimes prematurely, such as the Zhengzhou New District.

The Government is encouraging both public and private housing development in an effort to solve the housing shortage. The “which is better, Communist or capitalist housing solutions?” debate was answered a generation ago by Deng Xiaoping, Mao’s second successor and architect of the modern Chinese economic miracle, who quoted a Szechwan proverb that it matters not whether a cat is black or white; if it can catch mice, then it is a good cat. This saying particularly resounds with me, as I have a black and white cat that catches numerous rodents, brings them into the house, and then forgets to kill them. Not a good cat.


"Chairman Meow" - Feline founder of a rodent "catch and release" program -- caught outdoors, then released into the Martin household. In debating communist vs. capitalist solutions to solve housing needs, Deng Xiaoping quoted a Szechuan proverb that it matters not whether a cat is black or white; if it can catch a mouse, it is a good cat. Deng may have been right about many things, but wrong about my cat. Both black and white and catches mice, but fails to kill them. Not "a good cat". Realistically -- is this the face of a mouse-killer?


High housing prices and rents

A joint Wharton/National University of Singapore study found that housing prices increased by 225% in the last 8 years and Beijing land prices increased by 800%.

There are anecdotal reports that Beijing housing prices average 27 times annual household income. Unlike in the Western world, mortgage loans are limited to no more than 50% of value; nevertheless, additional leverage is often obtained from close relatives.

In an American city, housing prices at 27 times annual household income would be a precursor of a bubble waiting to burst, but only because American housing purchases have become highly leveraged investments in which the homeowner can quickly owe more than the house is worth, incentivizing the homeowner to walk away from his home via foreclosure, short sale, or deed in lieu of foreclosure. It’s harder for a Chinese homeowner to walk away from substantial equity or loan obligations to family members.

The Chinese housing model is less dependent upon leverage, while the family residence is considered to be the most secure asset a family can own. This environment also attracts speculators, which the Government continues to try to quell with new policies to curb housing price inflation, most recently tne "Eight National Measures" whose policies include 1) no bank financing for third home purchases, 2) minimum cash down payments of 30% for first home purchases and 60% for second home purchases, and 3) restricting home sales to only "registered residents".

The hukou system classifies citizens by their place of origin, thus limiting their mobility or restricting the right to services in the cities they move to. Preferential treatment is extended to "registered residents". It creates an almost apartheid system pitting rural vs. urban residents. The hukou system of classifying residents limits home purchases in cities with housing shortages to "registered residents" or "migrant residents" who can establish that they have lived and paid taxes in the city for at least 5 years. ("Migrant residents" have become marginalized similarly to illegal aliens in American and British societies.)

The sale of homes held less than 5 years is also taxed. The Central Bank has also raised bank reserve requirements 16 times over the last year and a half to rein in bank lending. Reserves are now required to be 21.5% of deposits.

Residential rental property investments are also priced very high, with sales prices reflecting annual gross rent multipliers exceeding 40 -- even higher than in Singapore or Hong Kong.

The China Daily reports a study by the Chinese Academy of Social Sciences that property prices in Beijing and Shanghai are 30 to 50% above market value. Their definition of market value obviously differs from that of other countries, as "market value" usually represents the price that a property would sell for under ordinary arm's length conditions, a definition commonly used in the U.S. The idea that everything is selling at above market value suggests a different definition of market value than held in the U.S.

With the Beijing housing shortage, the renter is in a particularly difficult position. One computer graphic designer explained to me that he pays about 70% of his monthly income on rent for his Beijing apartment, a rent equivalent to about $1000 USD per month, double what he was paying 5 years ago. He explains that recent college graduates often form groups of 6 or even 8 to rent one apartment, dividing the living room into individual living units.

Those who might consider Beijing housing prices to be a bubble, should take note that most bubbles collapse from falling demand or supply increases well in excess of demand, which so far does not seem to be occurring in Beijing. In American housing bubbles, one can observe that the most supply-constricted markets, such as Manhattan or San Francisco, suffer the least depreciation in economic downturns. One thing that prolongs the Chinese Bubble, too, is the lack of property taxes, which makes carrying costs low for real estate speculators. This is starting to change, now, with the cities of Shanghai and Chongqing instituting residential property taxes, with assessment rates ranging from .4% to 1.2%. This could curb speculation, although Chinese investors have few other choices of investments; Chinese stocks are considered riskier investments than housing and are down about 25% this year.

One interesting twist to the Chinese housing market is that all properties are leasehold. The residential land leases from the government are 70 years in length. As is customary with leasehold properties, improvements must be removed by the end of the lease. This creates interesting repercussions for the Chinese housing market. What happens to resale value after a few decades? Will family heirs have considerably diminished hereditary rights to housing? What resale values are possible for older homes nearing the end of their 70-year leases? It will be interesting to watch this grand housing experiment.




An answer to the overpopulation problem? -- from engrish.com

Related articles

• Beijing property sales increase Jan-July
• Rents predicted to rise by 4 per cent due to shortage of decent properties and 'scarcity' of mortgage finance
• S&P: China's Housing Market Is Finally Looking Up